A Better Way to Close Maryland's Budget Gap

FREDERICK W. DERRICK and CHARLES E. SCOTT

October 15, 1991|By FREDERICK W. DERRICK and CHARLES E. SCOTT

The governor's budget cuts -- $450 million this time on top of $650 million last year -- strike at programs held dear by Marylanders. The cuts are real and hurt to the quick. In response, citizens are hopping on a bandwagon in support of raising the sales tax rate from 5 to 6 percent.

Paraphrasing ''The Chrestomathy,'' raising the sales tax rate as a solution to the state's complex budget problems is simple, plausible and wrong.

One cannot miss the irony that the governor's cuts were the deepest in the social programs for the economically disadvantaged, and that the revenue solution being proposed uses the most regressive tax in the state's arsenal. It would strike the same people!

The poorest in the state pay more than 3.5 percent of their incomes in direct sales taxes, while those at the upper end pay only 0.7 percent. But this comparison hides the true regressivity, because hidden in the final price of products are the sales taxes paid on business-to-business transactions, 58 percent of the total take. The insidious nature of the hidden portion of the sales tax is that it is passed forward through all products. Even products which the legislature has exempted from the sales tax have from 1.7 percent to 3.3 percent added into their final prices by the payment of sales tax at intermediate stages of production.

Thus the total impact of sales tax takes from Maryland's poorest more than 9.5 percent of their income. The wealthiest Marylanders spend only 2.5 percent of their income paying sales tax. Raising the rate to 6 percent will raise the the sales-tax burden on the poor to 11.4 percent of their income, but to only 3 percent for upper-income payers.

Raising the rate will perpetuate problems in the sales-tax base which lead to cyclic revenue problems. The state has exempted 82 percent of consumer spending from the sales tax. In a recession, not only do consumers spend less, but more of what (( they do spend is for nontaxed products. The effect of recession on state revenues is disproportionate to the severity of the recession itself.

Many exemptions were introduced to relieve the tax burden for the poor, but by exempting all food and all utilities, all consumers benefit. These exemptions are extremely expensive. Maryland forgoes approximately 13 percent of its potential sales-tax revenue by exempting food. More than a third of this tax relief, a tax subsidy in fact, goes to families with incomes over $50,000, while less than 14 percent goes to families at or below 1.25 times the poverty line.

Broadening the sales-tax base with an alternative provision for the poor may offer revenue stability over the business cycle. But removing business exemptions would further the competitive disadvantage faced by our industries from the current taxes on business-to-business transactions. Thus, the base broadening needs to be in the consumer portion of the base.

The inclusion of personal services would be sound tax policy, given the significant transition to a service economy since the early 1960s. Taxing personal services would raise sales-tax revenue by more than 12 percent and would continue revenue growth as the service sector grows in importance. Including personal services, however, would reduce sales-tax regressivity only slightly.

Alternatively, the base can be expanded by allowing the exemptions to apply to only the deserving poor. The traditional mechanism employed, the tax credit, taxes goods over the year and refunds the sales tax paid by the poor at the end of the year. Most legislatures have rejected this option in favor of more expensive exemptions because of the administrative difficulties in serving the poor and because credits take money from the poor to return it at the end of the year.

We propose a radically new approach in directing the exemptions to the needy, the negative tax credit. The negative tax credit would provide an exemption for specified products at the time of purchase to all consumers and collect the tax due by the nonpoor at the end of the year. The implementation of a negative tax credit for food could raise between 8 and 11 percent more revenue for Maryland than the current food exemption -- and it would significantly reduce the regressivity of the current sales tax.

In effect, the negative tax credit targets the revenue-collection effort to those who can afford the tax, rather than the revenue-reimbursement effort to those deemed needy of tax relief after they have paid the tax. The amount of the negative credit can be based on family size and income. It can be administered through the income tax. The negative tax credit offers the state a means of simultaneously raising both revenue and tax fairness.

Frederick W. Derrick and Charles E. Scott, economics professors at Loyola College, provided background analysis on the sales tax to the Linowes Commission for its report on state finances.